Monday, May 23, 2011

Power shortages in China

Manufacturers in the PRC are complaining about power shortages. Reports of electricity being cut for 1-3 days a week in some areas are common. Electricity shortages are adding to the problems of rising raw material costs, rising labour costs and currency appreciation which businesses in China now face. To make matters worse, the peak season for electricity demand is over the summer months and a number of power stations will experience disruptions to operations due to scheduled maintenance work. In short, the situation is expected to worsen.

The cause of the problem is fairly basic: a shortage of coal to use as fuel in China's power generators. Given the comparative global abundance of coal (of most grades), at first glance this is surprising. However, the reasons for a shortage of coal are also not hard to identify: increased demand, price controls and a much needed government plan to "clean up" the appalling safety and environmental standards of China's coal mining industry. Of these, the price controls are the easiest to deal with - simply remove the controls.

While one would also think that reduced electricity consumption would be a good thing for the environment, its not. Many of the manufacturers affected by disruption to their power supply will fall back on diesel powered generators which produce more pollution than coal generators.

From an investment perspective, the case for investing in coal companies looks quite good (I already hold a large position in Yangzhou Coal (HK:1171)). China's leading coal mining companies typically have very solid balance sheets and sell at reasonable forward looking valuation multiples (if you believe the forecasts). The greater risk to the sector is the possibility of further price controls being adopted. Logically, additional price controls would lead to further shortages, but since when has either logic or historical experience had much impact on government policy?

The coal shortage also makes the case for investing in China's nuclear programme and possibly some clean tech companies (about which I know relatively little). I also took a look at IPP sector but struggled with both the highly leveraged balance sheets and the PRC government's efforts to tame inflation through price controls.